MENU

Does Efficient Market Hypothesis Hold Water?

EMHEfficient market hypothesis (EMH) is a widely researched topic by academics and it is also taught in business schools. EMH states that the prices of stocks always tend to reflect everything that is known about the prospects of individual companies and the economy. This implies that stock prices cannot be predicted and that no amount of fundamental research will give investors an edge.

So, does EMH hold water?

I believe EMH is false, to a large extent. Let’s look at why EMH does not hold water.

Bubbles

There have been a number of bubbles in the stock market’s history. The first recorded bubble was Tulip mania, which happened in 1637. More recent ones would be the dot-com bubble in 2000 and the housing bubble in 2007.

Bubbles happen when the price of an underlying asset rises too much from the fundamentals of the asset. In 2000, before the dot-com bubble burst, Yahoo! traded at a price-to-earnings or P/E of 952. At its peak, the P/E was a whopping 1,893! It would take 1,893 years of earnings to get back the purchase price. No one lives that long, let alone 952 years.

Market Crashes

Market crashes happen due to unsustainably elevated prices seen during bubbles. During the housing bubble in 2007 to 2009, the Straits Times Index (SGX: ^STI) fell 58.1%. Blue-chip stocks such as Singapore Exchange Limited (SGX: S68) and CapitaLand Limited (SGX: C31) plunged even more, 73.3% and 78.4% respectively.

If EMH was entirely true, bubbles would not happen in the first place and neither would the ensuing busts.

Beating the Market

Warren Buffett once said he believes that there are exploitable “pockets of inefficiency” in the market. That is why from 1965 to 2012, Buffett’s company, Berkshire Hathaway, trounced the market as represented by the Standard & Poor’s 500 index (S&P 500). Berkshire had a compounded annual gain of 19.7% versus the S&P 500’s 9.4%.

Reversion to Intrinsic Value

On the other hand, the markets are slightly efficient. This is why the price of a stock reverts to its intrinsic value in the long-term.

If EMH doesn’t hold water at all, then investing would be futile as our share price will not appreciate to its true value at all. I would rather sock my money away in the bank.

Foolish Takeaway

Warren Buffett would have not been successful in the stock market if EMH was entirely true. He quipped once: “I’d be a bum on the street with a tin cup if the markets were always efficient”.

Click here now for your FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by David Kuo, Take Stock Singapore tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.  

Like us on Facebook   to keep up-to-date with our latest news and articles. The Motley Fool’s purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.  Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.